Mini Chapter Six
Rate Option Strategies
Since I’ve already discussed all basic strategies as part of the FX/Equities options earlier, drawing a parallel with interest rate options won’t need as much detail unless we speak of pure rates curvature-driven option strategies like conditional spreads. Directionally lower rates strategies are usually structured with receivers in formats like – outright receivers, receiver spreads, receiver flies, receiver ladders, conditional bull steepeners or flatteners among others. Exposure to volatility regardless of direction is generally taken via longer expiry straddles/strangles, calendar spreads (sell short expiry to buy longer expiry on the underlying swap).
We would go through lower rates strategies here so as a corollary it becomes easier to understand the higher rates ones.
Receiver Spreads
- Can be thought of either as a bear (put) spread on interest rates or a bull (call) spread on bonds. This is typically structured as a purchase of an at the money forward receiver and selling an out of the money forward (lower rate strike) receiver to cheapen the structure, for the same notional and expiry. Intuitively this is a bet on lower rates versus what’s currently implied by the forward yield, with the pay-off capped once we hit the out of the money strike.
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- Both strikes may well be out of the money in case of a stronger conviction for a directional move lower in rates.
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- Play on the Greeks – It’s a positive net delta exposure at inception with gamma and vega values the maximum and positive if the long strike is ATMF. Delta trajectory peaks in between the strikes while gamma and vega start coming off as the underlying rate moves away from ATMF and flips to negative values closer to the short side of the option. Option Theta is negative (value decays with time) for underlying interest rate values at or close to the long strike and has positive values as the underlying trades closer to the short strike.
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- Receiver flies – are the same as structuring a butterfly with receivers with the same expiry and underlying swap tenor, i.e. buying a lower and higher strike as the wings and selling twice the notional on the intermediate strike (typically mid-point of the range). The higher strike wing would imply being long a receiver spread while the lower strike would be like being short the spread, the intermediate strike being the short leg both times. As discussed earlier, the strategy doesn’t account for skews in the vol smile (unlike an outright non-ATMF receiver and or risk reversal) and is a conservative view on the underlying remaining within the long receivers range. Greeks would play out in the same manner as for a standard butterfly covered in Option strategies.  Â
- Receiver ladders – are a series of receiver options structured to cheapen the overall structure, a long receiver ladder position is a purchase of an OTM receiver and sale of two respective more OTM (lower strikes) receivers to finance it, all for the same expiry. Receiver swaption being the same as a put option on an interest rates, this position is the same as a long put ladder on rates. A short position would be just the reverse i.e. buying the two lower strike receivers and selling the least OTM (or ATM even) to finance it. Strikes can be chosen to either make the structure zero cost or delta neutral or minimal net vega but it’s viability – strike placement – would depend on any skew on the vol smile (implied vols across strikes for an expiry).
Refer to the pay-offs of a long/short call and put ladders before we make further observations. K1 is the long/short strike while K2 and K3 are the more OTM short/long strikes for the respective long/short Call and Put ladders:
Graph 2-5: Pay off graphs on Long/Short Call/Put Ladders
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- Referencing the pay-offs above, a long ladder position has limited profit potential and can suffer unlimited loss (if the underlying goes far above/below the most OTM strike for a call/put ladder. Conviction to put on this position would come from a range-bound but directionally higher (in case of a call)/lower (in case of a put) view for the underlying. This would appear more tenable in a low vol backdrop.
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- A short ladder exposure on the other hand is an exchange of limited risk for unlimited profit potential if the underlying were to move significantly higher or lower typically in a high vol backdrop. You can think of this position as a tail hedge for a portfolio that wants to protect against unforeseen blow-up events.
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- A long receiver ladder exposure into say the Silicon Valley Bank blow-up (completely unforeseen in an otherwise strong inflation/growth, almost goldilocks, backdrop) would have inflicted major portfolio losses. Short receiver ladder would have been a great hedge.
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- Greeks of the strategy – A long ladder exposure would be short gamma, short vega and long theta while a short ladder exposure would be long gamma, long vega and short theta. Note that the rationale for the strategy shows up in the direction of gamma and vega exposure respectively.
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- Trivia – Swaptions for Pension LDI
Coming back to the use of rate options for this investor segment, interest rate hedges are frequently timed with vanilla strategies but broader usage of swaptions and strikes on them would be a function of a) basis risk i.e. different discount factors for liabilities and the swaps meant to hedge interest rate risks the liabilities are exposed to b) gap risks on the underlying i.e. knee-jerk sell-offs that could create a hard trade-off between immediate rates hedging (eg. buying bonds if rates have sold off beyond target levels) or retaining the optionality c) widening bond-swap spreads d) vol term structure and payer/receiver skews, among others.
- Selling OTM Payer swaptions – where strike is placed at specific target levels high enough to trade off the improving funding ratio (lower present value of liabilities as discount rates increase) with going long interest rates. The premium earned by selling the swaptions also helps finance the purchase of fixed income assets once target levels are hit, but a meaningful sell-off beyond target levels would bleed funding (remember on the exercised swaption the LDI fund is received fixed at the strike).Â
- To prepare for a rates sell-off that’s bigger than the LDI manager expected, multiple payer swaptions can be sold at different strikes for better use of funding to hedge rates risks and attain better average entry levels on received positions.Â
- Swaption collars – the sale of an OTM payer can finance the purchase of an OTM receiver when the LDI manager is also conscious to hedge against a sudden collapse in rates. These are typically zero cost structures where in a rising rates backdrop, higher implied vols for higher strikes (topside skew) can finance OTM receiver strikes that are closer to ATMF, affording better downside protection.
